Jobs and Inflation and the Intersection of Monetary and Fiscal Policy

The U.S. job machine remains engaged. After a strong 231,000 net new payroll jobs were created in June, another 209,000 were created in July. In five of the first seven months of this year, more than 200,000 net new payroll jobs were created. While it looks like the rate of payroll job growth has stepped down from the robust pace of 2014 and 2015, it remains strong. The U.S. unemployment rate was back down to 4.3 percent in July and is set to go lower. However, despite several different data points that suggest that the U.S. labor market is very tight, wages have not increased as much as expected. That is not to say that they have not increased. Through 2015, average hourly earnings for private sector workers were up about 2 percent year-over-year. That has stepped up to about 2.5 percent year-over-year growth in the four months ending in July. However, it is fair to say that wages are not yet driving inflation up.

Economic theory says that late in the business cycle, when labor markets get tight, inflation starts to accelerate. The reality so far has not lived up to the theory. The headline Consumer Price Index in July was up by just 1.7 percent over the previous 12 months, under the Federal Reserve’s “comfort zone” of near 2 percent. After removing volatile food and energy prices, core CPI for July was up the same 1.7 percent over the past year.

The divergence between economic theory and recent performance has created some tension for monetary policy makers. Normally, the Federal Reserve increases the benchmark fed funds rate aggressively in the latter stages of an economic expansion as inflation heats up. The fed funds effective rate was increased from 5.9 percent in September 1986 to 9.9 percent in March 1989, ahead of a surge in the CPI to an eventual high of 6.4 percent year-over-year growth in October 1990. Likewise, the fed funds effective rate was raised from a low of 1.0 percent in June 2004, to a high of 5.3 percent in July of 2007, coincident with the CPI climbing to a peak 4.2 percent year-over-year increase in June 2006. Now, inflation is still muted after 96 months of economic expansion, and the Fed has only slowly raised the fed funds effective rate from near zero through November 2015 to 1.2 percent in July 2017.

We expect the Federal Reserve to leave the benchmark fed funds rate unchanged at the conclusion of the next Federal Open Market Committee meeting on September 20. We look for FOMC Chair Janet Yellen to announce on September 20 that the next chapter of monetary policy will begin this October with the phasing in of balance sheet reduction. The Fed’s goal with balance sheet reduction is to gradually ramp up the amount of maturing assets that will not be reinvested and allowed to roll off the Fed’s balance sheet. We expect this to have a small tightening effect on liquidity in U.S. financial markets. The goal of the Fed is to have the program “running in the background,” so that it is not a lever in the management of monetary policy. It could take several years for the Fed’s balance sheet to shrink to the target size.

The Fed may then resume fed funds rate increases at the FOMC meeting of December 12-13. The current implied probability of a December 13 fed funds rate hike, as determined by the fed funds futures market, is about 50 percent. One key issue for the U.S. economy over the next several months is the Trump Administration’s success or failure with their fiscal policy agenda. The federal debt ceiling debate looms large after Labor Day. Tax reform will likely have a contentious path through Congress later this fall. Perhaps infrastructure spending comes next year.

For a PDF version of the complete Comerica U.S. Monthly with additional commentary, tables, and charts, click here: US_Economic_Outlook_0817.